Real Estate vs. Bonds: “Inflation Shelter” vs. “Naked and Afraid”

As of 5/2/14, the US 10 year Treasury is yielding 2.6%, whereas average real estate cap rates (essentially an unlevered yield) range from 4.5% to 7.5% depending on the market and asset type.

As these are average cap rates, some real estate markets and product types off investors even higher returns – the markets we’re buying in consistently offer 8-11% unlevered yields.

Many would argue that real estate’s current return premium is justified due to the increased risk profile of real estate. Let’s explore that assertion.

Bonds – Risk Free / Return Fee Returns

Academics and investment professionals deem the current paltry US treasury yield as the “risk free” rate. Of course, this isn’t entirely accurate. While the Government can raise taxes and print money to pay its bills, it’s not an absolute certainty that the Government will never default on its debt holdings (its bonds).

While I believe it’s highly unlikely to occur anytime soon, empires do fall and usually it’s due to balance sheet problems. 16th Century Spain, pre-revolutionary France and the Ottoman Empire were all crushed by debt. Spain was arguable the world’s first superpower, with an unrivaled Armada and an unwieldy, expensive empire that defaulted on its debt no less than 14 times in roughly 150 years.

Furthermore, in today’s artificially low interest rate environment, long duration bonds (especially bond funds) actually appear quite risky. Interest rates only have one way to go from their current basement levels. When interest rates eventually revert to their historical mean, bond prices will decline. While direct bondholders can avoid principal losses by holding their bonds through maturity, it’s unlikely those dollars will have the same purchasing power as when those bonds were purchased.

Inflation via Printing Press – Implicit, “Sneaky” Default

In case you weren’t aware, the US government is addicted to debt.

Our National debt is now over $17.5 trillion. How do we dig ourselves out of this wealth sucking black hole? Every American family knows the most conservative approach to reducing debt is through austerity measures that curtail discretionary spending.

In other words, tighten the belt and stop blowing cash on stuff you don’t need. However, it appears that US politicians have neither the fortitude nor the politically capital to address necessary but difficult entitlement reforms.

Perhaps avoiding spending cuts was the right move (austerity measures have prolonged the recovery in many countries), only time will tell. But if we’re going to ignore the balance sheet, the only other alternative is to slowly devalue our currency. This is precisely what the Fed is doing by purchasing massive amounts of new bond issuances (quantitative easing) and keeping the federal funds rate at near 0% for an unprecedented period of time. These measures have all but assured future inflation.

The devaluing of US currency will combat the government’s massive debt problem by reducing the real value of US nominal debt, which is a clever way to default on current debt obligations as the Government can pay back bond holders with “cheaper” money. This is just a subtle way to renege on our national debt as it avoids the panic associated with the following newspaper headline, “US Defaults on Debt For First Time in History, Confidence and Stock Market Collapses”.

So, in summary, bonds currently offer investors:

Meager yields (likely negative real returns)

Heightened probability of principal loss (if interest rates rise and bonds are not held to maturity);

A chance to lend even more money to your Uncle with the crazy addition to credit cards, you know… Uncle Sam. I’m not a rehab expert, but continuing to bail him out with additional loans so he can pay the interest on his debt (hello Ponzi scheme) isn’t going to encourage him to change his profligate ways.

Alternatively, you can invest directly in real estate, which offers investors significantly higher returns and a strong inflation hedge.

Real Estate’s Inflationary Advantages

According to a recent study commissioned by TIAA-CREF, commercial real estate returns have beaten inflation over 5 year holding periods with 84% probability1. The study also confirmed that, over the short term, commercial real estate returns are moderately correlated (.38) with inflation while the 10 year Treasury is negatively correlated (-.29) with inflation.

Many investors that do not own real estate are nonetheless aware of its ability to mitigate the effects of inflation. Consequently, when inflation starts to take hold, new buyers help support real estate valuations.

On the negative side, inflation should lead to higher interest rates, which (while not perfectly correlated) will likely lead to higher cap rates. However, as mentioned, the property’s higher NOI could offset or even over-compensate for this impact.

Couple these advantages with real estate’s forced principal pay down and incredible tax benefits (depreciation, interest deduction, 1031 exchanges) and its pretty much throw in the towel time for bonds. While bonds will always have a place in diversified investment portfolios.

I believe investors that need capital appreciation and current income from their portfolios should allocate more funds to direct real estate over bonds.

Personally, my investment portfolio will always be overweight direct real holdings and underweight fixed income, as I trust my ability to make sound real estate investments over the Federal Reserve’s ability to control inflation.

Free eBook from BiggerPockets!

Get The Ultimate Beginnner's Guide to Real
Estate Investing for FREE - read by more than 100,000 people -
AND get exclusive real estate investing tips, tricks, and techniques
delievered straight to your inbox twice weekly!

9 Comments

Our interest rates are soooo low, that it can only go up in the future. The principal will adjust down to keep the rate the same, and you will lose long term. When I found this out I pulled all of my money out of the market.

Very smartly written. I agree. I too have worried about QE and debt and inflation. I see what you mean about politicians too. Entitlement reform would be helpful. It’s just not feasible to start two wars, cut taxes, and weather a financial storm brought about largely due to lax government regulations on their corporate donors (the financial industry). Tack on a Great Recession and that equals massive debt. Though I get spending is part of the problem, we have a major, systemic, political-economic perfect storm that is evidenced by a lack of attention to infrastructure, a massive spying complex, weak education, misplaced priorities (spending one solitary second on $hit like denying climate change or evolution) and the biggie: wealth inequality and the shrinking middle class. I am sure you are aware that our health care system was in shambles before reform began a couple years ago, and our tax rates are among the lowest in the industrialized world. Canada recently overtook the US in the % of citizens in the middle class. We are weakening, and I just want to point out that the tired “Democrats are addicted I spending” refrain is simplistic and wrongheaded.

If you were speakong about a business or individual I could understand. However you were speaking about the federal government of the United States of America, which is the monopoly supplier of the US Dollar, I.e. a currency issuer whereas businesses and yiu and I and states are currency users. The only way for the federal government to default on its debt In our current monetary system is if they choose to. Austerity from the federal government is not only foolish but mathmatically guaranteed to fail to produce the desired results. The 7 instances in US history when the federal government has run a surplus or very close, we have immediately entered a recession or depression following this event. It is increasingly true now as our trade deficit eeds to have the counterbalance in order to provide stability and growth potential to the private sector. The US “debt ratio” has never been improved by cutting spwnding but always, every time by our economy growing out of a poor ratio.

At the end of the day, with all the data at hand I wonder why more people don’t look at the hustory and say the US federal government has injected capital (ran a deficit) into the private sector for 97% of its history, maybe there is a reason for that. Maybe that is the way it is supposed to be and somehow I have been thinking and looking at this wrong my entire life. Thus happened to me. I invest a heck of a lot better now that I have a solid grasp of the operstional realities if our monetary system. Visit pragcap.com if you want to learn more, it could change your life in more ways than one. Of course it does turn a lot of common kniwlwdge on its head so read for an hour a day for a month and search for logical flaws… good day

While I appreciate the intent of the article, I’d like a source for the assertion that US Treasury bonds are “risky”. I’m not aware of any economists asserting that a default is likely.
Also, I don’t think anyone is comparing bonds to REI and trying to make a decision. They are very different investments for very different circumstances. One is completely passive, and the other is definitely not. They also have different tax, liquidity, and other implications. It’s like arguing over whether a Porsche or a house is better. It all depends on your situation.

Brad, I’d like to challenge you to a car race around a course that features hills and curves and several straightaways. We will both race in Porsche 911s …. 5 speeds

But you can only use one gear throughout the whole course.

Who do you think will win?

The comparison that you make (actually TIAA-CREF) between real estate returns and 10-year Treasuries is similarly biased. By definition, it takes 10 years for a 10 year Treasury to reset (shift gears) while it takes only one year for real estate leases (most anyway) to reset (shift)

While I don’t want to dive deeply into the topic, there are many more types of risk that default risk. Most observers declare US Treasury debt to be “risk free” only in the context of default. Treasuries and any investment are subject to inflationary (and deflationary) risks, reinvestment risk, liquidity risk (almost zero for Treasuries) etc.